Online alternative lenders offer a variety of advantages from their use of automation, big data and crowdfunding to reach small businesses. They offer quick loan decisions with a stripped-down application process. These firms assess risk immediately with efficient use of algorithms and technology. Money can be distributed in days, not months.
But for too many small businesses, getting financing from one of these lenders is like the Wild West.
Advertisements for quick cash — once the domain of those lending to individual consumers — are more and more promising the same to small businesses. Internet searches for "small business loan" find sites offering "Up to $500,000 in 24 Hours," "10-minute application," and "get approved and funded instantly."
But data shows the process is anything but easy and affordable for many small businesses. Right before the end of 2015, California's Department of Business Oversight (DBO) sent "an online survey to 14 marketplace lenders requesting five-year trend data about their loan and investor funding programs." The DBO aggregated the findings. Nationally, from 2010-14, the dollar amount of these 14 companies' small-business financing transactions increased by 630% — from $400 million to $3 billion. Through the first half of 2015, transactions totaled $2.26 billion. The majority of their loans carried higher APRs, ranging from 41% to 101% or higher.
Another recent study by Opportunity Fund, a mission-driven lender, analyzed the type of financing that is offered to their small-business clients by competing merchant cash advance companies, alternative lenders that provide financing to small businesses. The study, the first of its kind, looked at 104 small businesses that were involved in 150 financing transactions from 54 different alternative lenders. Many of the borrowers in the study had been stuck with loans they just couldn't afford. The average alternative financing carried an annual percentage rate of 94%, with one loan reaching 358%. The average monthly loan was almost double the net income available to the small-business owners.
Not all online financing fits into the "borrower beware" category. Some online players, such as Lending Club and Funding Circle, have adopted responsible lending practices and can be a source of affordable capital. Square offers an easily understood cash advance, and Intuit directs its customers into vetted, honest products. Online alternative financing can be an efficient source of capital.
But it can also be predatory, especially to the unaware, inexperienced borrower.
Some lenders have tried to hide their true costs by making their offerings appear inexpensive and easy to obtain, but they often have short repayment terms (less than a year) coupled with daily or weekly payment cycles. As we've seen with small-dollar consumer financing, those types of structures can lead to financial ruin. Some particularly unappealing products have double-dipping clauses (meaning you pay twice on the same loan) and don't consider a borrower's ability to pay back in the financing decision. Some obfuscate the true interest rate costs by charging fees and prepayment penalties, and some have confidentiality clauses that won't let borrowers disclose terms to a third party.
Despite some initial movements by policymakers to explore regulating marketplace lenders, this sector is still falling through the regulatory cracks.
Here are three steps to taming the Wild West of online small-business financing:
1. Educate small businesses. Every small business that seeks capital needs to understand easy online cash. Every small business needs to know what "honest" capital looks like, i.e. transparent and affordable money that is essential to healthy local businesses and economic growth. They should know about the Small Business Borrower's Bill of Rights, which focuses on transparency, fairness and the interest of the borrowers. Additionally, those who can should endorse the Borrower's Bill of Rights to promote best practices in lending.
2. Demand a comprehensive study into the characteristics and effects of short-term, high-cost alternative financing on small business. We need more than one study of 150 transactions.
3. And I hate to say it, but we need some rules. Oversight of this industry essentially is nonexistent. Many of the merchant cash advance businesses are not regulated as lenders because they do not technically provide loans — and fall through the cracks of the law.
Claudia Viek is the chief executive officer of the California Association for Micro Enterprise Opportunity. She is the former executive director of the Renaissance Entrepreneurship Center.